Cannabis Science Masters The Art Of Shareholder Dilution

Several weeks ago, I shared my initial thoughts on a group of penny stocks that had enjoyed a massive rally in the past few months following the elections which saw the expansion of medical marijuana and the legalization for recreational use in two states, calling the run-up a bubble as I described "reefer madness". I followed up with a look at two of the most popular stocks in the space, both connected to the "King of Pot" Bruce Perlowin, Medical Marijuana Inc. (OTCPK:MJNA), which engaged in a questionable transaction with CannaVest (FCLS.OB), and then Hemp Inc. (OTCPK:HEMP), which has snookered the public with its gigantic preferred stock that inflates its market cap dramatically, leaving the company, which is devoid of any real revenue besides sales of MJNA.PK, at a ridiculous valuation.

It appears to me that many of the investors in these penny stocks are not getting a shot at participating in what surely will be a rapidly growing industry as marijuana is decriminalized in the coming years. Rather, they are buying a proverbial bag of oregano, enabling their "dealers", who excel at enriching themselves by printing shares of their stock at will. In this article, I want to examine what may be one of the most legitimate companies in the space, Cannabis Science, Inc.(OTCQB:CBIS). Sadly, here too there are just too many red flags and the valuation makes no sense.

History

Based in Colorado Springs, the company was formed in 2009, when K&D Equities exchanged 10.6mm shares of common stock for Cannex Therapeutics, based in California (2.1mm shares from the company, 8.5mm from K&D). Cannex was run by Steve Kubby (yes, the same guy who is running KUSH, which just entered a deal with HEMP.PK as I previously described). Kubby was appointed President and CEO, Richard Cowan as Director and CFO and Robert Melamede PhD as Director and Chief Scientific Officer. The company changed its name to Cannabis Science, Inc. to become a medical marijuana R&D company. Three months later, Kubby was gone, resigning amidst an internal investigation related to financial improprieties described in this SEC filing.

Today, the company is led by CEO Dr. Robert Melamede, a tenured professor and the former chairman of the Biology at the University of Colorado (Colorado Springs campus). He also serves as CFO. The company hired a new General Counsel in November, Chad Johnson, who, according to the press release, brings a strong background, including an undergraduate degree in Economics and a J.D. from Harvard and several years with law firm Skadden Arps Slate Meagher & Flom. He has spent the last 12 years pursuing several different causes related to LGBT issues and AIDS. More recently, the company announced last month that Richard Ogden, PhD, formerly Director of Scientific Affairs, HIV at Pfizer, had joined as a director and as Chief Scientific Officer.

Here is how the company describes itself:

Cannabis Science, Inc. is at the forefront of cannabinoid research and development for unmet medical needs. The Company works with leading experts in HIV and cancer drug development, medicinal characterization, and clinical research to develop, produce, and commercialize phytocannabinoid-based pharmaceutical products.

It describes its two key pre-clinical efforts:

Cannabis Science is currently working to develop preclinical investigations of CS-S/BCC-1 treatment of basal and squamous cell carcinomas. The Company has begun preclinical investigations, which are being initiated in Europe for squamous/basal cell carcinomas and Kaposi's Sarcoma based on inhibition of carcinogenicity utilizing cannabinoids that have been demonstrated in recent studies to significantly affect tumor necrosis.

Cannabis Science's research of CS-TATI-1 will be targeted to newly diagnosed patients infected with drug resistant virus, treatment experienced patients with drug-resistant HIV strains, and those intolerant of currently available therapies. Cannabis Science will be pursuing a wide range of NIH-based Federal Research Programs such as RO1's, PO1's and SBIRS which exist to support preclinical development of target validation and proof of concept studies. These studies will be implemented through collaborations with leading scientific institutions. Cannabis Science will also be pursuing other clinical research collaborations including the AIDS Clinical Trials Groups {ACTG}, the Canadian AIDS Trial Network (CATN) and the European AIDS Trial Network (EATN).

Most recently, the company described a transaction where it sold the company's rights and interest in the dupetit Natural Products GmbH JV that it had acquired last July to X-Change Corporation (XCHC.PK). New General Counsel and Director Johnson is serving as Director, COO and General Counsel of XCHC.PK too.

The Good

A couple of things strike me favorably regarding CBIS.OB. First, it is an SEC filer,with audited financials. Second, some of the people involved seem quite legitimate. I have already shared the credentials of the three Directors. You can link to their full profiles and the rest of their executive team as well as their Scientific Advisor Board. What you will find are people with credentials such as:

FDA Chemist with a PhD from Cornell University

Molecular biologist with an MBA and 20 years of experience

John Hopkins and Cornell University graduate who has authored 15 papers on HIV/AIDS

A doctor with experience with Health and Human Services and with the CDC

Former Global Director of HIV Research for GlaxoSmithKline

RNA virus expert serving on John Hopkins faculty

One thing to note, though, is that as of 12/31/11, the company had only two full-time employees, per its 10-K filing.

The Bad

One of the more disturbing aspects of the story has been the very high turnover in key personnel. The CFO, Richard Cowan, resigned (as a Director too) but joined the Scientific Advisory Board in December. He is 73 and was formerly the President of NORML. COO Ray Dabney left too.

Another thing that stands out is that the company is spread too thin, lacking focus. It's hard enough trying to advance one drug with insufficient funding (described in detail below). Not only has the company engaged in early-stage drug development which takes years and lots of money, it has also gone off on tangents. It tried to acquire a weight-loss center, TrimCare (owned by Goldsmith Health Care) in June, but the deal never closed properly and was unwound. Finally, from its 10-K:

Cannabis Science is laying a solid foundation for entrance into the FDA and other government regulatory agencies for developing medicines for cancer, autism, Influenza, PTSD and other ailments.

Our business and product development will follow two parallel paths. We will create cannabis pharmaceuticals with and without psychoactive properties. Both of these lines will have numerous proven health benefits for treating autism, blood pressure, cancer and cancer side effects, along with other illnesses, including for general health maintenance.

We are positioned to pursue the development of phytocannabinoid-based pharmaceutical grade products. The endocannabinoid system normally regulates blood pressure through its capacity to dilate blood vessels and reduce adrenergic stimuli. Additionally, there is a developing body of evidence that shows both the tumor killing properties of endo- and phyto- cannabinoids, and their ability to inhibit metastasis in a variety of cancers.

The Company is working to navigate the regulatory framework for its phytocannabinoid science towards developing cannabis-based therapeutics that will holistically promote health by restoring biochemical balance. By adhering to underlying scientific principles, the Company will manipulate all-pervasive phytocannabinoid processes to target a variety of disparate illnesses.

Cannabis Science is also positioning to explore insights that indicate an intrinsic link between novel cancer and HIV technologies and the cannabinoid system; with the goal of demonstrating that our pharmaceuticals will enhance biochemical markers that are indicative of a successful HIV therapy based on recent paradigm breaking discoveries.

The Company is currently focused on FDA approval of its first medical cannabis product targeted for veterans. Many veterans are already using herbal cannabis to self-medicate to relieve the symptoms of PTSD. Consequently, there is a clear need for standardized, FDA approved, oral cannabis products which can, and should be, provided to veterans and others who can benefit from its use. Medical cannabis has far fewer and milder side effects than most currently prescribed pharmaceutical products do. We are working hard to have one or more products ready for FDA clinical trials as soon as possible.

That is awfully aspirational for a company that reported that it had two full-time employees as of 12/2011.

The Ugly

Once again, shareholders seem blind to the capital structure. A careful read of the most recent SEC filing, the 10-Q from Q3, indicates the presence of an exploding share-count:

The 10-Q lists 714.54mm shares outstanding as of 11/19. This is up from 686mm as of 9/30. For perspective, there were 305.4mm outstanding at the end of 2011, 101.17mm at the end of 2010 and 29.744mm at the end of 2009. Yes, in less than three years, the common shares outstanding have increased 24-fold. There are 850mm shares authorized. Additionally, there are another 100mm "A" shares authorized but none outstanding (10 votes each). Finally, there are 1mm preferred shares, each with 1000 votes (i.e. more votes than common and "A" shares authorized). There are actually 999,999 outstanding, as they were issued "for services" in 2009. It is not clear who owns these, but originally they were held 1/3 each by Cowan and Melamede and the other 1/3 not specified.

Further, there is "Going Concern" language. While many have responded to my previous mentions of this type of language as "common to all penny stocks" and "boiler-plate", I urge anyone considering investing in the stock to pay close attention. This is about as close as you will come in life to having a crystal ball in my view (source: 10-Q):

The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles, which contemplate the continuation of the Company as a going concern. The Company reported an accumulated deficit of $84,641,820 and had a stockholder's deficit of $1,553,686 at September 30, 2012.

In view of the matters described, there is substantial doubt as to the Company's ability to continue as a going concern without a significant infusion of capital. At September 30, 2012, the Company had minimal operations. There can be no assurance that management will be successful in implementing its plans. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We anticipate that we will have to raise additional capital to fund operations over the next 12 months. To the extent that we are required to raise additional funds to acquire research and growing facilities, and to cover costs of operations, we intend to do so through additional public or private offerings of debt or equity securities. There are no commitments or arrangements for other offerings in place, no guaranties that any such financings would be forthcoming, or as to the terms of any such financings. Any future financing may involve substantial dilution to existing investors. We had been relying on our common stock to pay third parties for services which has resulted substantial dilution to existing investors.

The bold emphasis is mine. Just in case you don't believe them, this is what they said as of year-end in their amended 10-K:

The accompanying financial statements have been prepared in conformity with generally accepted accounting principles, which contemplate the continuation of the Company as a going concern. The Company reported an accumulated deficit of $70,536,669 and had a stockholder's deficit of $2,230,401 at December 31, 2011.

In view of the matters described, there is substantial doubt as to the Company's ability to continue as a going concern without a significant infusion of capital. At December 31, 2011, the Company had no direct operations and one license agreement for its products. There can be no assurance that management will be successful in implementing its plans. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We anticipate that we will have to raise additional capital to fund operations over the next 12 months. To the extent that we are required to raise additional funds to acquire research and growing facilities, and to cover costs of operations, we intend to do so through additional public or private offerings of debt or equity securities. There are no commitments or arrangements for other offerings in place, no guaranties that any such financings would be forthcoming, or as to the terms of any such financings. Any future financing may involve substantial dilution to existing investors. We had been relying on our common stock to pay third parties for services which has resulted in substantial dilution to existing investors.

Here is how the company described its liquidity in the Q3 10-Q:

The Company has a working capital deficit of $2,707,106 as of September 30, 2012 compared to a working capital deficit of $2,285,622 for the year ended December 31, 2011. There are insufficient liquid assets to meet current liabilities or sustain operations through 2012 and beyond and the Company must raise additional capital to cover the working capital deficit. Management is working on plans to raise additional capital through private placements and lending facilities. The Company currently is relying on continuing loans from stockholders to meet its obligations and sustain operations.

The Company has promissory note payment commitments of $870,177 due to stockholders over the next 12 months beginning on July 11, 2012 through September 30, 2013.

They have "capital resource" requirements too:

The Company has capital resource requirements for supplies, laboratory and scientific equipment of approximately $625,000 over the next 12 months. These capital disbursements are dependent on management's successful raising of capital through private placements and lending facilities.

Not to worry, though, they can rely on the revenue from their license deal, right? Nope.

The Company had license revenues of $0 for the quarter ended September 30, 2012 compared to $62,044 for the comparative prior year quarter. This decrease resulted from the Company's license agreement with Rockbrook that was breached in 2011 and still under dispute into 2012.

Thanks to acquisitions (GGECO University, which is now Cannabis Science University, and Cannabis Consulting Inc., which was formerly operated by their current Director of Investor Relations, Robert Kane), they did have course and consulting revenue of $1,848. Plus, they had $750 of interest earned. The sad part of this revenue is how much it cost them. They issued Kane 1mm shares ($147K) along with 250K free-trading shares ($25K) for "services rendered". GGECO cost 25mm shares ($935K, or $984K with assumed liabilities). These acquisitions, which closed in Q1 and cost over $1mm (in shares), generated $1,848 in sales two quarters later.

Adding insult to injury for shareholders is how the company further uses monopoly money. In the three months ended 9/30/12, they issued stock at prices well below the fair market price to settle debts. While the public is buying stock on the open market at much higher prices, the company is handing out stock valued at 1/10th of a penny:

On July 20, 2012, the Company issued 30,000,000 common shares for settlement of $30,000 of stockholder debt, for a loss on settlement of $1,530,000, assigned from the stockholder notes payable originating on August 4, 2011, September 26, 2011 and September 30, 2011.

I don't think I need to go on, but the company is handing out huge awards to management too:

On February 9, 2012, the Company signed a license agreement with Apothecary Genetics Investments LLC. to produce several Cannabis Science Brand Formulations for the California medical cannabis market. As well, Apothecary will provide research and development facilities with full circle operations including a California laboratory facility for internal research and development, along with 16 unique genetic strains specifically generated and maintained by a cancer survivor who recognizes the importance of proper growth and breeding. The Company earned a $25,000 license fee under the agreement for the period ended September 30, 2012.

In consideration of this agreement, on January 1, 2012, the Company entered into a 25 year management agreement with Dr. Mohammad Afaneh to act Chief Operating Officer of Cannabis Science, Inc. Dr. Afaneh received 28,500,000 common shares valued at $299,250 under this agreement. In addition, on February 10, 2012, Dr. Afaneh signed a management bonus agreement where he received 5,000,000 common shares valued at $185,000 as a signing bonus for entering into his management agreement. In addition, on January 1, 2012, the Company entered into a 25 year management agreement with Bret Bogue to act as Director of Horticulture and head of research and development. Mr. Bogue received 28,500,000 common shares valued at $299,250 under this agreement. In addition, on February 10, 2012, Mr. Bogue signed a management bonus agreement where he received 5,000,000 common shares valued at $185,000 as a signing bonus for entering into his management agreement. These common shares were issued on April 24, 2012.

Conclusion

CBIS.OB is extremely overvalued at 7 cents, sporting a market cap of at least $50mm despite dire financial condition. While investors should be impressed with the quality of some of the people involved with the company, they are years away from commercial success and lack the funding to get there.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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